U.S. Stocks Are Investors' Best Bet

With Europe and BRIC markets still on shaky ground, we need to find comfort where we can, which makes the US stocks surprisingly attractive. Investors may have a decent opportunity to make money right under their noses, and they don’t want to hear about it.

I’m talking about US stocks, which have very quietly put up decent numbers. I’m not talking shoot-the-lights-out returns—if that’s what you’re looking for, you really need to get a grip.

But those few investors who have stuck it out in US equities have managed to do OK over the last couple of years, and certainly much better than those who took flyers on “sure growth bets” like emerging markets.

Only US Treasury bonds are hated more, and they were by far the best-performing asset class last year. “The entire market has been wrong about fixed income for the last five years,” says Jay Kloepfer, director of capital markets and alternatives research at Callan Associates in San Francisco.

Callan is the creator of the well-known Periodic Table of Investment Returns, which shows graphically which asset classes were the best and worst performers every year.

The firm hasn’t published its latest version (including 2011) yet, but preliminary data suggest US stocks ranked near the top last year. The S&P 500 index just about broke even in a year when markets like China’s lost 20%.

Now before you start firing off comments, let me assure you I don’t work for Wall Street, the mutual fund industry, or the US government. And I don’t make money if you follow my advice.

But I happen to think investing in US stocks is a good idea for any US-based investor who wants to grow his or her nest egg. And though I don’t recommend a big stock position for anyone (no more than 50% of your assets), I would keep two-thirds of your equity holdings in US stocks.

Why? Mostly because the US economy isn’t as bad as so many people think it is.

Yes, unemployment is going to remain high for years to come, and that will hurt a lot of people. But investing is all about change, specifically the direction of that change, and from that standpoint the economy and employment are moving in the right direction. We’ve had private sector job growth for 22 consecutive months, manufacturing is rebounding, and consumer spending is pretty strong.

“The US economy is improving. It’s improving very slowly,” says Richard Bernstein, the former chief investment strategist for Merrill Lynch who is now CEO of Richard Bernstein Advisors in New York. “Ultimately the trend is in the US’s favor.”

Bernstein has preferred US equities to emerging market stocks for some time. In fact, he says the S&P 500 has outperformed the BRICs (Brazil, Russia, India, and China) over the last four years, from 2008 to 2011.

US companies are starting to bring jobs back to the US, because the total costs of making goods here are lower and the American workforce is so productive. Last week, The Wall Street Journalreported that wage and benefit costs at a Caterpillar (NYSE:CAT) plant in Illinois are less than half of what they are at another plant across the border in Ontario, Canada.

For what it’s worth (given their track records), economists project the US GDP will grow by more than 2% this year. That’s no great shakes, but it’s a lot more than we’ll see in Europe and Japan.

While we’re on the subject, European debt crises sparked big corrections in global markets in both 2010 and 2011, and investors are deeply worried about when the other shoe will drop. Italy and Spain have hundreds of billions of dollars of debt to refinance in 2012, so there may be another mini-panic in the months ahead.

But unlike their European cousins, US banks have little exposure to European sovereign debt, and our stress tests were tougher than Europe’s were. Most importantly, US financial institutions used the TARP program and the rally induced by the Federal Reserve’s zero-interest-rate policy to raise tens of billions of dollars of capital from private investors. European banks are trying to do that now in a much more challenging market.

Of course, a global financial crisis centered on European banks and sovereign debt would hit our markets hard. But a mild recession in some European countries wouldn’t. Only 14% of S&P 500 companies’ revenues came from Europe in 2010, according to S&P Capital IQ.

Meanwhile, non-financial companies in the S&P 500 have $2 trillion in cash on their books, estimates JPMorgan Chase(NYSE:JPM). They’re talking stock buybacks and dividend hikes, which could effectively put a floor under US share prices.

Earnings growth is slowing from the torrid double-digit pace it posted earlier in the cycle. Mid-single-digit percentage increases are more likely now. But earnings are still rising, and when you add in dividend payments we’re looking at modest returns of maybe 5% to 6% after inflation. I’ll take it!

Many investors won’t, however. US investors pulled more than $70 billion from funds investing in US stocks in 2011. Meanwhile, they continued to pour money into underperforming emerging markets through the middle of the year.

Clearly, too many people have drunk the Kool-Aid of “US declining, emerging markets growing” brewed up by Wall Street over the last decade. Others may be put off by the toxic political environment in the US.

Bernstein is happy that so many investors are still running the other way. “I think the fact that people are so skittish is good,” he told me. “US investors are myopic. The US will feast on the rest of the world’s problems.”

And finally there’s the calendar. Presidential election years generally are good for markets, and so is the strong start we’ve had in 2012. According to The Stock Trader’s Almanac, when stocks are up the first five days of January, they posted full-year gains 86.8% of the time.

Now here’s a word of caution: The S&P 500 has rallied 15% from its early October low of around 1,000, and stocks are due for a pullback, perhaps along with a reprise of the euro jitters.

Also, at around 13 times this year’s projected earnings, the S&P may not be expensive, but it isn’t so cheap, either. I’d wait for a correction into the low 1,200s or high 1,100s to buy.

Bernstein likes small-cap US stocks, because they’re more domestically oriented, and he thinks investors “should still hold some Treasuries for diversification.”

Says Kloepfer of Callan: “High-quality growth companies are in really good shape; profit margins are high, balance sheets are strong.”

What would I buy? I think we’re pretty late in this cyclical bull market, so I’d avoid the high flyers that just had big gains; that won’t last.

Instead, I’d recommend funds which own stocks that are increasing their dividends. My faves: Vanguard Dividend Appreciation ETF (NYSEARCA:VIG) and its mutual fund cousin, Vanguard Dividend Growth (VDIGX), which I’ve owned for years.

Yes, dividend-paying stocks have had a nice run, and everyone loves them—everyone who’s in equities, that is. But for the many investors who aren’t, it’s a good way to stay invested while limiting your risk and collecting a 2% yield, more than you’d get on a shorter-term Treasury or money market fund. What’s not to like?

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